Macro Strategy: Resurgent vols

Positive sentiment from the China-US trade war truce dissipated quickly with the Dow plunging by 800 points overnight, dragging 10Y yields to 2.91%. Questions on trade, worries about US growth and perceived dovishness on the Fed all play a part in explaining these market moves. Concerns were also compounded by increasing news narrative on inverted curves and risks of a recession. Notably, the 2Y/10Y segment of the US Treasuries curve is now at 12bps, compressing by 8bps since the start of the month. The 2Y/5Y and the 3Y/5Y segments of the curve have already inverted as the rates space prices in a further US slowdown ahead.

The likely covering of short Treasuries futures positions (and position squaring ahead of the US holiday) probably exacerbated the move lower in US yields. This theme was visited by us multiple times this year as net short positions in the 10Y tenor build to record 756k contracts in late September. Since then, a sizable chunk has been unwound, but the net figure is still large (net -284k contracts as of late November). When 10Y yields broke support at 3%, more short covering probably followed. The next data point, which should capture the current risk-off period bears close watching. If positioning has turned closer to neutral, there would be greater scope for yields to rise again when risk aversion fades.

India: INR bonds to tread water ahead of RBI policy decision

India’s sovereign bonds will tread water ahead of today’s policy decision, eyeing any change in policy stance and directed liquidity measures. The RBI committee meets today, against a vastly different backdrop vs two months back. Odds of a rate hike have dwindled after the INR rose >5% vs USD, slip in US yields and oil prices that are down by a third. At home, October inflation eased to 3.3% YoY, vs target at 4%; there is an increasing likelihood that November’s will be sub-3%. 3Q growth points to a slowing growth momentum (see here). These together with prevailing high real rates lower the need for the RBI to tighten policy this week and rest of FY19. Today or February 2019’s meet is likely to be accompanied by a downward revision in RBI’s inflation (actual is 50-60bps below official trajectory) and growth estimates.

On liquidity, the RBI is likely to continue with OMO purchases and term repos, rather than cut the Cash Reserve Ratio (CRR) or unveil any other targeted measures. Instead, markets will look to the 14 December RBI Board meeting where discussions on NBFCs and related liquidity support is on the agenda.

Rather than policy, RBI’s persistent liquidity support via bond buybacks and the global risk environment will have a bigger say on the bond price action. RBI announced INR100bn OMOs for Nov (on top of INR400bn already undertaken), with another INR400bn in December. A total of INR1.5trn worth OMOs have been conducted in FY19 yet far, with prevailing liquidity shortfall suggesting more are in the pipeline. Street expectations have risen to a total of INR2.0-2.5trn for the year.

This large quantum of bond purchases has overshadowed any potential concern over fiscal performance, oil price bounce, a busy political period and bouts of weakness in global equities (case in point, the overnight sharp sell-off in the US). For the 10Y, a break below 7.6% opens 7.55% and a stronger support at 7.5%, back to April levels. Short-tenor papers continue to benefit from fading hike expectations and strong demand.

In the INR credit space, borrowing costs have eased but more modestly than Gsec yields. For instance, the spread between AA 10Y vs 10Y GSec yields has widened from 100bp in January to 170bp presently. The issuance pipeline is, nonetheless, more active, as corporates bank on the recent correction in borrowing costs and seek alternatives to commercial papers.